China Real Estate: On Financing The Public Rental Housing

Standard Chartered Credit Research had a trip to inland of China, and they came up with this presentation, which is an interesting read, although there are good reasons to be worried by some of the stories they are telling.

On two particular pages (i.e. page 20-21), it shows the public rental housing projects in Chongqing. The presentation cites that there are 21 public housing projects currently under development in Chongqing, providing a total of 40 million square meters of rental housing in the next 3 years. Of which, 90% of the area (36 million square meters) will be for residential use, while the remaining 10% (4 million square meter) will be for commercial use. The total investment in these project amounts to RMB100 billion.

Here's the big problem: the government will only put up 30% of the RMB100 billion of equity, while the remaining 70% of the investment is financed by bank loans at 5% interest rate. While the government is confident about the financing, I am much less sanguine.

Here is the math: At 5% interest rate per year for RMB70 billion loans, the interest expense per year will be RMB3.5 billion, and the maintenance costs for the projects will be RMB500 million, so the recurring expenses will be RMB4 billion per year.

Assuming the rental rate will be RMB11 per square meter and all the apartments will be occupied, the annual income will amount to about RMB4.75 billion per year, more than enough to pay the recurring interest expenses and maintenance costs.

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So how about the principal of RMB70 billion?

Well, the occupants will have options to buy the units they occupy in 5 years time at cost, implying a sales price of around RMB2,500 - 3,000 per square meter. If 30% of the saleable residential area are sold at the high-end estimate, the income will amount to around RMB32 billion. The remaining commercial area will be sold at RMB 10,000 per square meter, so the expected sales income for commercial area will be RMB40 billion. So within 5 years time, the government can receive RMB72 billion or more from the sales.

So what is the problem here?

The "margin of safety", if you will, is pretty narrow. If the occupancy rate is 84% or less, for instance, they won't even have enough revenue to pay the interest expenses and maintenance costs. The sales assumptions are also aggressive, with the margin of safety of RMB2 billion only. So practically if any of their sales assumptions turned out to be false in 5 years time, they would be unable to get RMB70 billion to repay the loans. Also, the investment of RMB100 billion to build 40 million square meter of floor area implies a cost per square meter of RMB 2,500, so the sales price assumption of RMB3,000 per square meter is probably not achievable if they are really meant to sell the residential area "at cost".

Or perhaps their assumptions are realistic as Chongqing is a highly populous city, but it gives us a glimpse on the financing for these kind projects by the local governments. The fact that the project is 70% debt-financed is quite worrying, as this is probably more levered than many of the publicly traded real estate companies. As the government has pledged to step up the investment in affordable housing and public rental housing, the case of Chongqing may probably be quite common.